InfoTech & Public Policy

Since tax season is upon us and tax day is right around the corner, I’d like to post about identity theft and fraud related to filing your tax return and getting your tax refund. I recently read an article about how email “phishing” scams are on the rise this tax season. In fact, these scams have exploded over 800% since last year, with the IRS reporting seven phishing schemes last year and 65 this year. These are not 65 cases of fraud, but rather 65 different scams that are targeting unsuspecting taxpayers by email. With the rise in popularity of e-filing (over 50% of taxpayers use online filing), many taxpayers are vulnerable to email scams – unsophisticated computer users might have the tendency to think that an email that says it is from the IRS probably is, just because they used the computer to file their return (perhaps after years of paper filing). The IRS cautions that they do not use email to communicate with taxpayers, and that any email claiming to be from the IRS is a phishing scam. They warn not to click on any links in the emails, warning that many of the fraudulent cites look almost identical to the legitimate sites – sometimes with the only difference being the clever camouflaging of the URL. The IRS website gives a list of things to look out for, and advice on protecting yourself. The article cites one case when the word “west” was spelled “vvest” in an address, and the rest of the site was a carbon copy of the real site. If you find a suspicious email in your inbox, the IRS urges you to forward it to phishing@irs.gov where they can work to shut down the fraudulent site and prevent any future fraud, if possible. The barriers to entry in the phishing game are very small because all you need is a computer and a list of email addresses. Furthermore, with many of these scams based out of the United States, it is hard for the IRS to stop the problem. Ultimately, the responsibility rests on the taxpayer to stay informed of the latest scams out there, and to avoid giving out their personal information. These phishing scams are just like other cases of identity theft which we have discussed, and the solution is still the same. Consumers must protect their personal information if they want to avoid getting burned.

Many students have posted to the courseblog concerning virtual worlds and the need to regulate them. On one side, are those who believe that regulation is ridiculous and unsustainable or that their real world irrelevance makes regulation unnecessary. Others argue that events in the virtual world have real world consequences on players and economics which necessitates real-world regulation

To a certain extent, both sides are talking past each other rather than engaging in a debate because the terms of debate have not yet been set. That is, with many other issues we have discussed the question was clear: online gambling is becoming a problem, find a solution that effectively curbs it given the technical possibilities and respects civil liberties. We knew the objective of intended regulation.

The rationale for regulation follows from societal perceptions of the (usually) economic and (sometimes) social consequences of an activity. For instance, we regulate financial market fraud because we believe having functioning capital market where investors can trade with confidence is necessary for a free market. That is, regulation is intended to foster behaviors deemed socially beneficial. On the other hand, we place many restrictions on gambling because we fear the ills it brings to society.

It is tempting to argue that people who spend all their time engrossed in MMORPGs are contributing nothing to the economy and therefore such activities should be discouraged. If one took this as a premise, then one might take the same attitude towards virtual world regulation as one does gambling[1]. However, simply because one is not churning out widgets in a factory does not mean one is not helping the economy. For instance, few would argue that watching a movie is a productive activity, but this form of entertainment is an important part of the American economy. In fact, we deem it to be so important that we have created a complex set of laws called copyrights to ‘incentivize’ the production of creative content. Without any consumers, products would have no purpose: all work and no play stifle the economy. If one is to justify regulations against virtual worlds, one would have to do so on the basis of negative externalities generated by online addiction, much as one might justify regulation of gambling based on gambling addiction. However, one would have to find significant negative externalities. As a society, we don’t believe in regulating behavior simply because it is “unsocial:” there are no rules barring you from being glued to your TV set or being a workaholic.

But there is another way to view virtual worlds, and that is as a platform for economic activity. The Second Life economy is booming: in January 2006, the Linden dollar equivalent of $5 million US was traded. If a sizable market springs up, then the government has a strong incentive to regulate n order to smooth out the rough edges of the free market. (Alternately, if one is of a libertarian persuasion, one could take the cynical view that the government will find a way to regulate any sizable market, especially when tax dollars are at risk.) Accepting the premise that virtual worlds are a perfectly legitimate (and socially desirable) medium in which to transact business, one would consider regulation (or the lack of it) to promote growth. This is not terribly unlike the stock market analogy: in both economically significant bits are being flipped in servers and these bits are redeemable for real and virtual services. However, it is difficult to say that the LindenX plays the same fundamental economic function that AMEX or NYSE does so any proposed regulation will have be tempered by this “irrelevance.”

The above is a discussion of two views of the purpose of government regulation. I don’t know if I subscribe to either view entirely; both have their strengths and shortcomings. Neither argument deals explicitly with the form and scope of regulation. On this point, I think Tim Wu made a good point. He gave a talk March 30^th on campus entitled “Who Controls the Internet?” in which he brought up the importance of physicality. Internet-based forms of punishment inflictable by game masters – lowering one’s score, or banishing someone from a site – do not seem to have an effect on certain individuals (consider, for instance the attacks by W-Hats on the Second-Life servers). However, even these people are afraid of real world sanctions that the government is capable of imposing – fines, prison time. While virtual punishments should be a first choice they sometimes need to be backed by real-world consequences.

            As Kevin Werbach was discussing some of the potential uses of a next generation wireless network he mentioned the prospect of every individual user having the capability to be a broadcaster.  In many ways this system sounds very similar or could easily have the potential to turn into another sort of file-sharing network.  Thus, along with some of the considerations for how spectrums should be assigned and regulated any policy discussion must also include how some of the intellectual property issues that accompany any file sharing network should be addressed. 

            As has been demonstrated by the many battles between the file sharing networks such as Napster and the recording industry there is a difficult tension between technological innovation and intellectual property rights.  Policy makers are in a position in which they are both aware of some of the potential issues that can come up as the wireless technology grows while the technology itself is not fully established.  If policy makers act now they can potentially use this new medium as a venue to try to find a better balance between technological innovation and intellectual property rights.

            One potential solution is to attach a small surcharge on the subscription fees to these new wireless networks.  This solution has been presented in the past as a way to compensate the recording industry without hindering the advancement of technology.  As these new wireless networks are setup they could potentially act as testing grounds for this new type of scheme.  Different artists could be compensated based upon how many times their song is downloaded.  If file-sharing networks were brought into the mainstream it would be easier to keep track of how many times a song was downloaded.  One potential way to keep track would be a system similar to how ad companies keep track of how many times an ad is clicked on.  If this system worked on a limited basis it could be enlarged to encompass more traditional internet connections as well. 

            Because this technology is just now being setup policy makers are in a position to incorporate a solution into its construction before another Napster situation arises.  New wireless networks such as those described by Werbach could lead to file sharing that is even harder to detect than BitTorrent sharing because the sharing could all be done on local networks.  Of course technology might never go down this path and this whole discussion could be a moot point. On the other hand, policy makers could actually encourage the technology to follow this path and by doing so solve one of the major problems surrounding the internet.  A solution like this could provide relatively free file-sharing networks (paid for by the fee a person pays to access the internet) and would eliminate the need for the RIAA to sue its own customers.  Much as Werbach was advocating un-licensing spectrums in order to allow technology to evolve un-licensing file-sharing networks could have much the same effect.

I’d like to take this opportunity to respond to a couple of the earlier posts.

First off, I disagree with Andrew’s call for an internet sales tax. While it is certainly true that the internet is no longer in its infancy and any tax, by definition, will be a market distortion, it is by no means clear that either of these are good reasons to implement a tax.

In response to the allegation that an internet tax would “subsidize” online shopping, I say “so what?” The decision to shop online instead of in person is affected by countless economic variables: the cost of shipping; the cost of transportation (for brick and mortar stores); the uncertainty of not being able to see your products; the trustworthiness of the vendor; the added return costs; and the greater customizability, to name a few. Whether the net effect (no pun intended) of these variables is to encourage or discourage online shopping is anyone’s guess. In all likelihood, it varies by customer.

That being said, encouraging online shopping has certain highly desirable effects. First, it acts as a sort of free trade mechanism between the several states. Through the internet, a consumer in any state can compare vendors from all states, in effect eliminating geography in all sorts of industries. Not only is this in line with the constitution (the Commerce Clause was put in place to allow businesses to compete in all states free of tariff), but it allows consumers to compare prices in a wide array of markets. Adding a tax to internet goods would cut into these gains.

This isn’t to say that the internet should remain entirely free of taxes. One area for revenue generation on the internet could be a tax on IP addresses. We talked in class about the possibility of an IP crunch in the near future. Well, a small tax on holding IPs would free up some of the truly underused addresses. Another area for taxation is a bandwidth tax. Bandwidth is the sort of good where a tax could have positive externalities. Like in the energy market, a floating tax could help free up valuable bandwidth during peak times and encourage use during low-volume hours.

Switching gears a little bit, I’d like to briefly address a couple points about regulating the internet. We’ve mentioned a lot of jurisdictional problems about regulating the internet, but jurisdictional problems should not preclude the possibility of any regulation. I think that in certain areas, the government can be effective even if it only targets its own citizens in limited ways. Consider software and music piracy. While the possibility of being sued by the RIAA hasn’t done much to discourage music theft, I think changing some of the incentives involved might work. Making music theft a criminal act, something involving jail time, say, would surely have a chilling effect on the entire business of stealing music. With online gambling, a legislative focus on end-users could similarly depress the entire market without running into the problem of prosecuting a server in the Cayman Islands. I think it’s important to keep in mind that we don’t need to get everyone for our laws to have a real effect.

Nine years ago it may have made sense that a person buying Wealth of Nations would pay taxes if the book was purchased at the Barnes and Noble on Route 1, but not if it was purchased at barnesandnoble.com. However, as Republican Senator Lamar Alexander said, “The Internet is not a baby in a crib anymore.” In the fourth quarter of 2005 alone, US retail e-commerce sales were $26.5 billion, a growth of 24% from the same period last year. Since its inception just over a decade ago, e-commerce has already risen to 2.3% of total retail sales, and its growth will only continue in the coming years. An Internet sales tax is an idea whose time has come.

An Internet sales tax makes sense for economic reasons. An efficient tax code should be clear, fair, and simple. Currently, e-commerce fails each of these tests.

The lack of clarity on Internet taxes creates confusion and hinders the ability of individuals to allocate their resources efficiently. Some merchants, like Sears and the Gap, collect taxes, while others don’t. The same opacity exists with state governments. Most citizens of California, Minnesota, and New York are unaware that their governments are enforcing a 1949 law called the Jenkins Act to collect back taxes on the sale of Internet cigarettes. Imagine their displeasure when they receive a tax bill for $500 in the mail.

The current situation is also unfair. The absence of a tax is effectively a subsidy for Internet businesses. Subsidies are inefficient, and put traditional retailers at a disadvantage. Internet merchants don’t need that support anymore, and as George noted in his post, there’s no clear evidence that instituting the tax will harm online sales. It would be interesting to determine if the negative externalities created by e-commerce, by way of extra packaging and shipping costs, are greater than those created by brick-and-mortar stores. Either way, a sales tax would reduce market distortions and internalize some of those externalities. Further, the honor system in which states require tax filers to pay voluntarily the tax they owe for online purchases doesn’t work, and only reinforces the “cheat or chump syndrome” of tax returns. For example, in 2003 less than 1% of Wisconsin taxpayers admitted they owe taxes on Internet or out-of-state purchases. Financially strapped states are losing billions of dollars in revenue that is rightfully theirs.

Finally, for the reasons above and as a result of the U.S. tax code itself, e-commerce taxation is far from simple. Critics of an Internet tax rightly point out how difficult it would be for merchants to apply the rules of 7,600 different taxing jurisdictions. Indeed, the ‘unduly burdensome’ nature of collecting taxes was the basis for the Supreme Court’s 1992 decision exempting Internet businesses from collecting most sales taxes.

But this complexity only supports the case for implementing a simple, broad Internet sales tax, and the Streamlined Sales Tax Project (SSTP) is doing just that. The District of Columbia and thirty-four states of this forty member coalition have approved a model agreement to streamline and simplify their sales taxes, and twenty states have enacted conforming legislation. They are also supporting the development of new technologies to administer the tax. At this time, collection remains voluntary. However, bills were introduced in the 108^th Congress to make collection mandatory. Adam Smith would approve.

This week in class, we talked a little bit about internet sales tax (and Phil also talked a little bit about it in his blog entry). It seemed that the issues of complexity in implementing such a sales tax, and the incentives it gives to online shopping were two major issues.

Regarding incentives, I agree that the lack (mostly) of sales tax from online retailers is a motivating factor to online shopping. Looking around for what others had to say about these motivations (just search for internet taxation), I found studies claiming that if an internet sales tax were enforced most people would not change their behavior. I also located some studies that concluded the exact opposite - that an internet sales tax would significantly detract from online sales. So while I agree that many people are pleased by the lack of sales tax, it seems an open question if enforcing it would significantly hurt online sales. I think that for most people for most purchases, they look at the listed price of the product (and maybe shipping) when comparison shopping. An article in the nytimes (http://www.nytimes.com/2006/02/12/business/yourmoney/12digi.html) had an interview with an economist talking about the varying behavior of online customers when the item price changed, but the overall price stayed the same.

“Academic research shows pretty convincingly that people have separate accounts in mind, one for the item itself and one for shipping,” said John Morgan, an economist who teaches at the University of California, Berkeley. Using eBay auctions as his real-world laboratory, he showed that changing the ratio of item price to shipping charge, while keeping the total price constant, produces sharply different customer responses.

In terms of complexity, the argument can be made that it is too complicated for an online retailer to maintain and update a listing of each state and local government’s taxation rates and rules. This would involved knowing which items are taxed and at which rates for each local area that an item is shipped to. Knowing the state is not good enough, because cities and (in some states) counties can augment the tax rate. Those local governments also give discounted rates during certain time of the year to inducing more commerce. This is not an online-only problem. The same complications apply to order over the phone or from mail catalogs, and since these existed before the internet, it seems that it is just an application of those rules to all distance shopping (including online shopping). While there may be a complex set of sales tax rules to follow for merchants selling all over the country, abiding by them is not impossible. In fact, companies with both a large online and offline presence (think target.com, bestbuy.com, walmart.com) already have to deal with this issue. Assuming those stores have a presence in most states, they will have to calculate the sales tax for most of their in the customers depending on the address. Since this is something that is already done by some companies, it doesn’t seem that the complexity would be prohibitive from enforcing it.

Internet gaming has grown explosively over the recent years, and in Tuesday’s class we discussed the legal and practical implications of policing America’s online gambling addiction. I do not think there is an easy way to attack the offshore gaming servers because they fall out of the United States’ jurisdiction. I think one of the only ways to slow the explosive growth of this industry is to go after individuals in a very public way. Some will counter with the argument that this is exactly what the RIAA has attempted, with little success in the fight against internet piracy. Speaking from personal experience, I can say that when the RIAA started bringing lawsuits against Princeton students, I abruptly stopped any illegal file sharing in which I may or may not have been participating. I wasn’t alone – most of my friends and roommates also saw the RIAA’s actions as a very credible threat, and the probability of being sued (while small) was magnified in our minds. Their actions succeeded in changing our decisions.

I feel that internet gaming is similar. If the government made public examples of online gambling offenders, not only would some people stop playing because of the potential consequences, players would realize that what they were doing was actually illegal. Right now few online players realize that the poker and other casino games they are recreationally playing are illegal in their states. While I cannot speak for everybody, personally I think that public enforcement of the laws concerning online gaming would affect my decision to play or not to play.

On the issue of internet sales taxes, I think that the lack of a sales tax is an incentive to shop online. This is especially the case if you can escape the shipping costs. The issue that was brought up in class about there being three addresses for every online transaction – the location of the merchant, the shipping address, and the billing address – is an interesting one to consider. I think that any policy regarding online sales tax should focus on one of these addresses for all transactions in the interest of simplicity. It would probably be easiest if the tax was the responsibility of the merchant because they would be the most likely (more so than the consumer) to have the administrative capabilities to process the paperwork involved in documenting and paying the taxes. The taxes could then be distributed throughout the merchant’s home state.

Until next week…